Debt can quickly become overwhelming, especially if you’re juggling multiple high-interest balances and struggling to make minimum payments. One possible solution is debt settlement, which involves negotiating with your creditors to pay less than what you owe, usually in one lump sum payment. But is debt settlement a good idea?
While it might seem like an attractive way out, the debt settlement process can take years to complete, come with steep fees, and do serious harm to your credit. Before you choose this option, it’s important to understand how debt settlement works, the risks involved, and what alternatives may be available.
Table of Contents
Key Points
• Debt settlement involves negotiating with creditors to reduce the total amount owed, often through one lump-sum payment.
• You can try debt settlement on your own but it is typically done through a third-party debt settlement company.
• High fees and credit damage are significant risks associated with debt settlement.
• A debt settlement program can take several years and success is not guaranteed.
• Alternatives like credit counseling or debt consolidation may be better options depending on your financial situation.
What Is Debt Settlement?
Debt settlement, also known as debt relief, is the process of negotiating with your creditors to pay less than the full amount you owe. Instead of paying off your debt over time, you reach an agreement — typically through a debt settlement company — where the creditor accepts a lump-sum payment that’s typically less than your outstanding balance.
Debt settlement programs usually focus on unsecured debts, which aren’t tied to a physical asset like a house or car. Examples include credit cards, store cards, medical bills, and old debts in collections. Secured debts such as mortgages, car loans, student loans, and tax debt, typically don’t qualify for these programs.
Though debt settlement is a potential alternative to bankruptcy, the process is seldom fast or simple and can have significant financial and credit consequences.
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How Debt Settlement Works
Since creditors typically only consider settlement if they suspect you won’t pay at all, a settlement company will typically advise you to stop making payments on your debts right away and instead put your monthly payments in a dedicated savings account set up by the settlement company.
Once you have enough money saved for a lump-sum offer, the settlement company will attempt to negotiate with your creditors to accept a lower one-time payment to satisfy the debt.
If your creditors agree to debt settlement, you pay the negotiated amount, as well as the debt settlement company’s fees. At that point, the debt is marked as “settled” or “paid for less than the full balance” and the creditor can no longer hound you for payments or take you to court for that particular debt.
While that may sound like a welcome reprieve, keep in mind that this whole process can take up to three to four years (during which fees and interest on your debt continue to mount), and it isn’t always successful.
What Is a Debt Settlement Company?
A debt settlement or debt relief company is a for-profit business that offers to arrange settlement of your debt with lenders or debt collection agencies.
Debt settlement companies often require an initial consultation so they can determine whether you qualify for their debt relief program and which option might fit your situation. You might be asked to provide basic information regarding your current creditors, debt balances, monthly income, and expenses.
While debt settlement companies typically charge a fee for their services, a reputable relief company will not ask you to pay any money up front. By law, settlement companies are only allowed to charge you a settlement fee once a successful result is reached and you have made at least once payment to the creditor.
Fees and Payment Structure
Debt settlement companies typically charge a fee of 15% to 25% of the amount you owe. For example, if you owe $15,000, and the debt settlement company charges a settlement fee of 25%, you’ll pay them $3,750 once the settlement is complete, in addition to paying the settled amount to your creditor.
In some cases, debt settlement companies may also charge other fees, such as a set-up fee to open the dedicated savings account and a monthly fee to maintain the account. However, they generally cannot collect these fees until they successfully settle at least one enrolled debt.
Why Is Debt Settlement Risky?
While debt settlement might sound like a fast way to get out of high-interest debt, it carries several risks that could potentially leave you worse off than before. Here are some key things to keep in mind.
Debt Settlement Can Be Expensive
Between the lump-sum payments to creditors and the settlement company’s fees, you may not save as much money as you expect. If negotiations fail, you could still owe the full balance — plus late fees and interest.
Debt Settlement Can Damage Your Credit
Because debt settlement often requires you to stop making payments, your accounts will become past due, and your credit score can drop significantly. This damage can linger for years, making it harder to qualify for loans, rent housing, or even get certain jobs. (See below for more information on exactly how debt settlement impacts your credit.)
There’s No Guarantee Debt Settlement Will Work
Creditors aren’t obligated to accept a debt settlement. Some may refuse to work with a debt settlement company outright. Those that are willing to negotiate may not accept the settlement offer. If a deal doesn’t go through, you’ll still be out the fees and interest that accrued on your debt during the process, leaving you worse off than you were before you entered the debt settlement program.
Tax Consequences of Settled Debt
The Internal Revenue Service (IRS) generally regards forgiven debt as income. So if you are able to settle your debt for less than what you, any amount that is wiped off your balance may be taxable. Your creditor may send you (and the IRS) a Form 1099-C, “Cancellation of Debt.” Even if you don’t receive a form, you may still be required to report the forgiven amount as “other income” on your tax return. It’s a good idea to consult with an accountant or tax advisor if you have any forgiven debt.
How Does Debt Settlement Affect Your Credit Scores?
Debt settlement can significantly impact your credit. Here’s how:
• Missed/late payments: Any payments you don’t make leading to debt settlement will be reported to the credit bureaus after 30 days. Payment history is the most important factor in your credit score, so any late or missed payments listed on your credit file can do major damage to your credit.
• Increased credit utilization: As interest accrues on your credit cards, your credit utilization ratio (how much of your available credit you’re using) will increase. Higher utilization can negatively impact your credit profile.
• Accounts may go to collections: After several months of nonpayment, your creditor may send your account to collections. This debt will be marked as a collections account on your credit report, which can negatively impact your credit.
• Settled accounts on your credit reports: If your account is successfully settled, your creditor will report it as “settled” rather than “paid in full.” Settled accounts can be a red flag for future lenders and stay on your credit report for seven years.
Debt Relief vs. Debt Consolidation
Debt relief often refers to debt settlement, which involves working with a third-party settlement company to resolve your unpaid debts. They will negotiate on your behalf with creditors in hopes of getting portions of your debt forgiven. Debt consolidation, on the other hand, typically involves paying off one or more existing debts with a new loan or credit card, ideally with a lower interest rate. This can simplify repayment and potentially help you save money.
While debt consolidation aims to help you pay off your full balance over time, debt settlement focuses on reducing the total you owe, often at the cost of your credit score and financial stability.
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Pros and Cons of Debt Settlement
Like most financial strategies, debt settlement has both benefits and drawbacks. Here are some to keep in mind:
Pros of Debt Settlement
• Potential to reduce total debt owed: If negotiations succeed, you may pay significantly less than your original balance.
• Avoid bankruptcy: Settlement may help you steer clear of the more severe consequences of bankruptcy.
• Stop harassment from creditors: Once a debt is settled, creditors and debt collectors can no longer hound you for the debt.
• Faster resolution: If you have cash on hand to settle your debt, you could resolve your debt faster than through long-term repayment plans.
Cons of Debt Settlement
• Credit damage: Missed payments and settlement status can hurt your credit for years.
• High fees: Settlement company charges can be steep, which negates some of the benefits of debt settlement.
• No guarantees: Creditors don’t have to agree to settle.
• Tax implications: Forgiven debt can be treated as taxable income.
Beware of Debt Settlement Scams
Unfortunately, the debt settlement industry has attracted bad actors. Some companies make unrealistic promises, charge high upfront fees, or disappear after collecting your money.
Signs of a potential scam include:
• Asking for large upfront payments before settling any debt
• Guaranteeing that they can settle all your debts for a specific amount
• Saying they can stop all debt collection calls or lawsuits
• Starting enrollment without any review of a your financial situation
• Claiming there is a “new government program” that they are assisting with
• Advising you to stop communicating with your creditors without explaining the risks
Before committing, it’s important to research companies thoroughly, check their accreditation and standing with organizations like the American Fair Credit Council (AFCC) or International Association of Professional Debt Arbitrators (IAPDA), and read customer reviews.
Debt Settlement Alternatives
Before opting for debt settlement, it’s wise to consider other debt payoff strategies that may be less risky and have a smaller impact on your credit.
Credit Counseling
Nonprofit credit counseling agencies offer free or low-cost advice on budgeting and debt repayment options. A credit counselor can help you create a personalized plan to pay down debt without resorting to settlement. If you’re struggling with debt, this is generally one of the safest places to start.
Talking to Creditors
Sometimes, simply calling your creditors and explaining your situation can lead to better terms. It’s generally in a creditor’s interest to help you avoid default, so they may agree to a reduced interest rate, waived fees, or an extended repayment term. This can make monthly payments more affordable without harming your credit or having to resort to debt settlement.
Balance Transfer
A balance transfer involves taking out a new credit card and using it to pay off your current credit card balances. If your credit score is still in good shape, you might qualify for a balance transfer card with a 0% introductory annual percentage rate (APR). This can give you a window — often 12 to 21 months — to pay down debt without interest piling up.
Just be aware that balance transfer cards usually charge a 3.0% to 5.0% transfer fee on the transferred amount. Also, if you don’t pay off the balance within the promotional period, the interest rate will jump, potentially undoing your progress.
Fixed-Rate Personal Loan
Interest rates on personal loans are generally much lower than credit cards, especially if you have strong credit. If you can qualify for a competitive rate on a personal loan for debt consolidation and use it to pay off your high-interest debt, it could help you save money and potentially pay off your debt faster. Debt consolidation can also simplify repayment by rolling multiple debts into one monthly payment.
💡 Quick Tip: Before choosing a personal loan, ask about the lender’s fees: origination, prepayment, late fees, etc. One question can save you many dollars.
Debt Management Plans
Debt management plans (DMPs) are offered by credit counseling agencies. For a small fee, a counselor will negotiate with your creditors on your behalf to lower interest charges and fees, and come up with a manageable repayment plan. You then make a single monthly payment to the agency and they distribute payments to your creditors.
Unlike debt settlement, you pay off your debt in full, just with more manageable terms. Keep in mind that DMPs typically require closing your credit accounts and you usually can’t access new credit during the plan.
The Takeaway
Debt settlement can seem like a lifeline when you’re drowning in bills, but it’s not without significant drawbacks. It can damage your credit, cost more than you expect, take years to complete, and there’s no guarantee of success. While it may work for some people — especially those facing severe financial hardship and unable to pursue other options — it’s far from a quick fix.
Before making a decision, it’s important to weigh the pros and cons carefully and explore safer alternatives like credit counseling or debt consolidation. The right debt solution is the one that not only addresses your current challenges but also supports your long-term financial health.
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FAQ
How much do debt settlement companies typically charge?
Debt settlement companies usually charge fees ranging from 15% to 25% of your total enrolled debt. So if you enroll $20,000 in debt and the fee is 20%, you could owe $4,000 in fees once the settlement is complete, in addition to paying the settled amount to your creditor. It’s important to review contracts carefully to ensure fees are transparent and avoid companies that demand advance payments.
Can debt settlement stop collection calls?
Debt settlement can stop collection calls, but not right away. Calls may not stop until you or a debt settlement company working for you negotiates a settlement with your creditor or debt collector and you pay the settled amount.
How long does debt settlement stay on your credit report?
Debt settlement typically remains on your credit report for up to seven years from the date the account first became delinquent. During that time, it can lower your credit score because it signals to lenders that you did not repay the full amount owed. The impact lessens over time, especially if you practice good credit habits afterward. Once the seven-year period passes, the record should automatically fall off your credit report, potentially improving your credit profile.
Is debt settlement better than bankruptcy?
Whether debt settlement is better than bankruptcy depends on your financial situation. Debt settlement may allow you to repay a reduced portion of what you owe without going through court, but it can still harm your credit for years. Bankruptcy, especially Chapter 7, may erase most debts faster but can stay on your credit report for up to 10 years and carry legal costs. Settlement is often better for moderate debt, while bankruptcy may suit extreme, unmanageable debt.
What should you look for in a legitimate debt settlement company?
A legitimate debt settlement company should be accredited by a reputable organization, such as the American Fair Credit Council, the International Association of Professional Debt Arbitrators, or the Consumer Debt Relief Initiative. They must also comply with the Federal Trade Commission’s (FTC) rule against upfront fees. In addition, they should provide a written agreement and be willing to explain the risks, including credit score impact. Avoid companies that guarantee results, pressure you to sign immediately, or make claims that sound too good to be true.
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